Venture-backed companies issuing common stock options should be aware of the valuation guidance provided in the AICPA Practice Aid Valuation of Privately-Held-Company Equity Securities Issued as Compensation. This Practice Aid prohibits the use of rules of thumb when valuing common stock relative to preferred shares. Instead, it lays out three methodologies for allocating equity value among the common and preferred shareholders.

Under the probability-weighted expected return method (PWERM), the value of a company’s common stock is estimated based upon an analysis of future equity values assuming various liquidity events, such as an IPO or sale. Share value is based upon the probability-weighted present value of expected future cash flows, considering each of the possible future events, as well as the rights and preferences of each share class.

According to the Practice Aid, “The primary virtue of this method is its conceptual merit, in that it explicitly considers the various terms of the shareholder agreements, including various rights of each share class, at the date in the future that those rights will either be executed or abandoned. However, the method may be complex to implement and requires a number of assumptions about future outcomes.”

Under the option-pricing method (OPM), each class of stock is modeled as a call option with a distinct claim on the enterprise value of the company. Just as an out-of-the-money option may have value, common stock may have value even when the value of the company’s equity is less than the liquidation preference on its preferred shares. With sufficient time and volatility, the equity value may rise above the liquidation preference, bringing the common stock “into the money.”

The option pricing method is complex to implement and sensitive to certain key assumptions, such as the volatility assumption, that are not readily subject to contemporaneous or subsequent validation. This method is appropriate to use if the range of possible future outcomes is so difficult to predict that forecasts would be highly speculative.

The current value method (CVM) is based on allocating the enterprise value of the company to the preferred stock based on the greater of the preferred stock's liquidation preference or conversion value. An assumption underlying this method is that each preferred shareholder will, at the valuation date, exercise its conversion rights in the matter most beneficial to such preferred shareholder.

Because the current value method focuses on the present and is not forward looking, the Practice Aid maintains that its usefulness is limited to two types of circumstances. The first occurs when a liquidity event is imminent. The second occurs when the enterprise is in a very early stage of development.

Valuations of privately-held common stock often include a discount for lack of marketability. Selecting the appropriate discount is a matter of judgment & expertise and those issues are discussed here.